Tuesday, July 09, 2013

Risk Parity: What’s Next?

Risk parity strategies are not supposed to shoot the lights out, and most agree that the strategy is a good starting point for building your portfolio.

What more then, should a modern risk parity product do for its clients? How can they adapt the original purpose of a risk parity fund--arguably launched in 1996 by Bridgewater--into one that is fit for purpose in today's volatile markets?
We're not alone in wondering this: the risk parity managers have been wondering it too.
Bridgewater is a good place to start: Almost immediately after the aforementioned Reuters article decrying the returns from All Weather had appeared, Bob Prince, CIO of Bridgewater, spoke to reassure investors of his strategy.
He also told them that he had already introduced interest rate hedges, to calm any further fears of rate rises hammering their portfolios.
But Prince insists this wasn't a knee-jerk reaction to recent rate rises. Instead, he claims the plan had been on the cards for months.
In a rare interview, Prince tells aiCIO that alarm bells were raised when All Weather started performing rather too well.
"If you look at our All Weather strategy it had much higher returns than we'd expected on a long-term basis," he says.
"It didn't reflect anything we did, as we manage the portfolio passively, but it reflects the compression of risk premiums and the decline in real yields.
"This raised our attention, and we asked 'now that the prices are up and the yields are down, we expect the returns will be lower, so what does that mean for us?'."
Is amending a portfolio an active decision? Or just a prudent passive move?
Bridgewater embarked on a research drive, analysing liquidity creation from central banks and how it affects economies and markets.
The production of liquidity initially drove down the yield of cash and short-term bonds, along with other near cash assets, and because of the risk aversion at the time, the money didn't really find its way out of the risk curve into higher risk assets.
Then in 2013, as risk aversion has gradually faded, money moved out of the curve into other assets, meaning credit spreads are down, real estate is doing better, the stock markets up and so forth.
Prince and Bridgewater decided to use what they'd learned to improve the structuring of All Weather strategy.
"As the discount rate changes, including the risk premiums and real yields, that drives prices up and reduces expected returns, and so our process led us to the obvious observation that the real yield are in all assets, not just in bonds," he says.
"And because real yields are part of the discount rate by which all assets are valued, we realised it had given us more real yield exposure than we really needed.
"To rebalance All Weather and improve the balance we hedged some of the real yield exposure. By doing that we've got the same Sharpe ratio but [we can also] produce a return that's as close to a straight line as possible over a long period of time."
Prince estimates that by taking some of that excess exposure to real yields out of the portfolio, he's improved the tracking of that straight line by around 20%.
Isn't this a rather active decision for a famously passive strategy to take though? Prince has previously gone on record saying the best risk parity strategy is a totally passive one.
Today, he argues that taking the decision to hedge against interest rate exposure isn't an active decision, but simply a strategic one. He describes it as "not really an earth-shattering change, more of an incremental improvement".
Prince is extremely keen to ensure his clients (and presumably the wider market) understand the difference "because it's so rare for us to do any sort of transactions in All Weather".
"We didn't want people to misunderstand what we were doing. It's a modest improvement. We didn't want people to misconstrue this as a tactical bet, as it's largely about finding better ways to structure a passive portfolio," he argues.
Could he prove that this wasn't a reactionary measure to the fallout from Bernanke's speech then? As is policy for Bridgewater, Prince can't reveal exactly when the trades were made, but he assures aiCIO: "We did it gradually over the past few months…certainly the research we'd been doing dates well beyond the [Fed announcement in May]."
Can he convince the doubters? Well, not all of them.
"I find the decision to introduce hedges really funny because fixed income is your hedge for equity, and now you've got a hedge on a hedge," says Arun Muralidhar, co-CIO of AlphaEngine Global Investment Solutions.
"If it's truly a hedge, what the hell are you hedging? That to me shows it's a dead man strategy--you've got all these guys signing up saying 'I want that strategy to be the core of my portfolio', but then you're left having to do stupid things like putting hedges on hedges.
"The reason Prince has added more hedges is because the passive strategy is flawed. In crazy dynamics like we have today, loading up on all three assets and leveraging it is setting yourself up for trouble."
Story continues… 

Tweaks, rebalancing and tactical overlays
Bridgewater's not the only manager introducing new ways of thinking about risk parity though.
Lombard Odier's head of multi-asset Aurele Storno told aiCIO his strategy features a "cushion mechanism" using dynamic drawdown management, which essentially acts as an insurance against bad periods.
"We know there are periods where nothing works. Any time we reach a high point with the fund, we capitalise on it and reduce our exposure to the market. And when the market goes down again, we reduce our leverage," he says.
AQR's portfolio manager Michael Mendelson places today's risk parity managers into two camps: those who are continually trying to adjust their position sizes and leverage based on the risk environment, and those who don't.
His employer is an example of the former. "As the risk level in the market has risen in the last couple of months, for the managers who fall into that first camp, they will have reduced their exposures in their fund," he says.
"The risk rises surprisingly haven't moved that dramatically, so it's reasonable to assume that there have been some moderate changes in positioning, but no big ones, and not necessarily across every asset class."
Don't tell him that his continual tweaking with the allocation and exposures is active, though. He'll completely disagree.
"You shouldn't think of it as tactical--we do it in order to be steady. Tactical to us means taking a view on things," he insists.
"We always want to be steady in risk, so when we make these adjustments it's to stay on our strategic target. You need to be able to make dollar position adjustments because market risk levels change.
"We also run risk parity plus funds with tactical overweights and underweights, and in those strategies we also then take [positions] to express model-based views on expected returns."
Redefining risk
Invesco's CIO, Scott Wolle, took a slightly different tack during his recent bout of research into how his strategy was performing--he decided to completely change the way he evaluated bond risk.
A common approach is to estimate the risk through looking at historical price volatility, but for Wolle, that looked counterintuitive when you consider the last 30 years has been an almost uninterrupted bull market, making bonds look safe as proverbial houses.
"What we chose to do was to use duration and convexity (a measure of the sensitivity of the duration of a bond to changes in interest rates--Editors) and the immediate impact was to reduce the allocation to bonds in our portfolio," Wolle explains.
"A year and a half ago it took 20-25 percentage points off of our bond allocation. And what we and others do is have a much higher commodity component to counter periods of inflationary growth, rather than use inflationary bonds."
That strategy hasn't been perfect either: Wolle freely admits in the past month it's been the commodities as much as anything else that have caused problems for the strategy.
Invesco also has a tactical component to its portfolio, where it compares asset performances against cash and decides whether they are attractive or not.
"Going into the correction we favoured equities, were relatively neutral on bonds and a bit underweight on commodities," he says.
"For us, the bonds are less a source of long-term return, although their value is a consideration, but the role we want gilts to play is as a safety asset, so when people argue that corporate bonds would be better than gilts, or that equities are more attractive than bonds, that maybe absolutely right, and we might look at it on a tactical basis, but what happens if you're wrong with that view? What happens if you go into a recession? Having the hedge against the unexpected happening is such a crucial element."
Also rethinking how to assess risk is Northwater Capital. Vice President Neil Simons says rather than just considering volatility risk, risk parity strategies should also consider tail risk and drawdown risk.
Tail risk represents the existence of infrequent but potentially large losses occurring over a short time frame within a particular asset class, while drawdown risk represents the potential across all asset classes for losses over an extended time. This situation is magnified when all of the assets within a portfolio drop simultaneously.
"We have an added layer of risk control that attempts to minimize these extended losses across the asset classes," Simons says.
By spotting that fewer asset classes were returning positive numbers by April, Simons used the drawdown control built into the strategy to help minimise the loss.
"It is essentially impossible for risk-parity portfolios to make money when all asset classes fall, however in constructing a risk-parity portfolio, an expanded view of risk can help to minimize losses when an environment such as the most recent environment occurs," he claims.
Will these subtle changes help reduce the pain investors feel when all assets plummet together in future? Only time will tell. But is it reassuring to see risk parity managers are no longer willing to rest on the laurels of their past five years' performance. Let us know if you're convinced.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.